Don't think you can fool the IRS

The IRS is cash-strapped and audit rates are down, but that doesn’t mean the average Jane or Joe can hide the ball from the tax man.

The tax-collecting agency devotes more resources to chasing big fish like convicted tax cheat Wesley Snipes than the average middle-class taxpayer, that’s true. But the IRS is now using sophisticated software and data analysis that puts it in touch with taxpayers before the official audit process begins.

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“Now with automation and the electronic submission of W-2s and 1099s, the IRS just matches the information,” said David Kautter, managing director of the Kogod Tax Center at American University. “If you don’t report something, it is almost automatic that you’ll get a letter from the IRS.”

The agency reported it reviewed less than 1 percent of all tax returns in 2013, compared with slightly over 1 percent the prior year, continuing a downward trend. The average audit rate in 1996 was about 2 percent.

Individuals with income topping $10 million saw an audit rate of more than 24 percent, while the rates for people who earned between $25,000 and $200,000 never climbed above 0.77 percent.

But the audit rates are somewhat misleading.

The vast majority of taxpayers receive W-2 forms that detail automatically generated earnings from an employer, bank or other institution. All of that information is simultaneously transmitted to the IRS and stored digitally. Agency computers can quickly and easily check to make sure the taxpayer’s figures match those reported by their employer or bank.

If the numbers are off, the computer typically sends the taxpayer a letter telling them to settle up, all before the audit process formally begins.

Most people make an honest effort to pay their taxes — the IRS reported this year that more than 85 percent of taxpayers voluntarily comply with the law, a number that has been consistent.

That’s good news as the IRS has become responsible for carrying out major social programs, from Obamacare to tax credits to support low-income workers — all while Congress has been slashing the agency’s budget.

But the strains have forced tax officials to be more strategic.

“What’s happening over the years is that the IRS has relied more on systems and less on traditional audits so the audit effort can be focused on places where there are real issues,” said Edward Kleinbard, a professor at the University of Southern California Gould School of Law and former chief of staff at the Joint Committee on Taxation. “The IRS has been significantly underfunded relative to the number of burdens placed on it.”

Audits are no longer the backbone of tax enforcement. Instead, they’ve become a strategic tool to target taxpayers who are claiming big deductions — like wealthy people donating to charity and small businesses writing off expenses.

“Wage-earning non-itemizers, for instance, have precious little room for mischief while business owners make a variety of judgment calls that could conceivably be called into question,” said Robert Kerr, senior director of government relations at the National Association of Enrolled Agents, which represents tax agents.

The system has critics, including National Taxpayer Advocate Nina Olson. The agency’s internal watchdog says that the increased reliance on automated letters means that the actual rate of IRS reaching out to taxpayers is actually closer to about 7.5 percent.

Olson has argued that these interactions exist in a middle ground of “unreal audits” that undermine a taxpayer’s right to challenge the assumptions made by the IRS. She also worries that low-income and middle-income taxpayers are most likely to be contacted automatically and the least able to afford representation to navigate the system.

But Kerr and many other observers point out that the IRS has very few options.

“We live in a world that values doing more with less, and you can sometimes do that until you reach the point where all you can do with less is less,” Kerr said. “It is a zero-sum game.”